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Chesapeake Energy

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Submitted By amhcdh09
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Andrew Hayes

Advanced Financial Management

Fall 2013

Controversy in Corporate Finance: Chesapeake Energy

Controversy in corporate finance is nothing new; it has been going on well before the term “corporation” was ever used. The power of money has always been an ongoing factor ever since humans started to use it to obtain goods and services. While, controversy over money is nothing new, controversy in corporate finance is much more complex and complicated, often requiring finance managers, accountants, and sometimes the SEC to sort everything out. Sometimes an executive or executive(s) get fired, sometimes they go to prison and sometimes they are given huge amounts of money to leave the company. Most of the time it seems like the latter of those options. As in the case of Chesapeake Energy, where the co-founder and CEO was given around 47 million dollars in salary, bonuses, perks, and stock options when he stepped down this year as CEO of the company due to controversial spending and declining cash flow revenue for the multi-billion dollar company. The controversy stems from a breach of financial ethics and decision making that is supposed to have the best interest of your shareholders in mind. Chesapeake Energy Corporation (NYSE: CHK) is the second-largest producer of natural gas, the 11th largest producer of oil and natural gas liquids and the most active driller of onshore wells in the U.S. Headquartered in Oklahoma City, the company's operations are focused on discovering and developing unconventional natural gas and oil fields onshore in the U.S. (CHK.com). Aubrey McClendon and
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Tom Ward with 10 employees and a $50,000 investment founded Chesapeake Energy in 1989. The company has had ups and downs throughout its 20 year history, including declining oil and natural gas prices in the late 1990s that prompted Chesapeake to switch their business model to focus more on natural gas production. This strategy proved successful as the company grew tremendously from 2003-2007 thanks to increases in natural gas prices. In 2005, the company was the 7th largest producer of natural gas and has since moved into the 2nd spot on that list. The company was even named “Best Managed Oil and Gas Company” in 2007 by Forbes magazine (Forbes, 2007). Chesapeake Energy has made billions by drilling for natural gas in a controversial way. Fracking, or hydraulic fracturing, is the process of extracting natural gas from shale rock layers deep within the earth (what-is-fracking.com). This process has led to numerous controversial articles and documentaries on the impact that it has on the environment and surrounding populations. Rolling Stone’s article, The Big Fracking Bubble: The Scam Behind Aubrey McClendon's Gas Boom, and HBO’s, Gasland, represent two of the many negative media responses to fracking of natural gas and Chesapeake Energy directly. However, according to these sources, Chesapeake has made most of their billions not by selling natural gas, but by flipping land it leases. For Chesapeake, the primary profit in fracking comes not from selling the gas itself, but from buying and flipping the land that contains the gas. The company is now the largest leaseholder in the United States, owning the drilling rights to some 15 million acres – an area more than twice the size of
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Maryland. McClendon has financed this land grab with junk bonds and complex partnerships and future production deals, creating a highly leveraged, deeply indebted company that has more in common with Enron than ExxonMobil (Goodell, 2012). Hence, this is just the beginning of their financial corporate crisis.
Bonds rated below Baa are termed high-yield, or junk bonds. Bond ratings are judgments about firms’ financial and business prospects (Principles of Corporate Finance, 2012). A company's debt, liabilities and risk are very important factors in understanding the company. Having an understanding of a company's debt and liabilities is a key component in understanding the risk of a company, thus aiding in the decision to invest, not to invest, or to stay invested in a company (Williams, 2012). In May of 2012, Standard & Poor's said plummeting natural gas prices and CEO Aubrey McClendon’s personal finances could hurt the company's cash-generating efforts. Uncertainty about the company's business and financial pictures led to the credit rating agency dropping Chesapeake's rating to "BB-," AP reported. This credit rating drop was the result of McClendon using business finance for personal finance, which created a huge controversy and prompted the SEC and IRS to start an investigation on Chesapeake and McClendon. Specifically, a Reuter’s investigation in April which found McClendon had arranged to personally borrow more than $1 billion from EIG Global Energy Partners, a firm that also is a big investor in Chesapeake. The loans, arranged through McClendon's personal shell companies, were secured by his interest in
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company wells. McClendon is allowed to take up to a 2.5 percent stake in every well Chesapeake drills under a controversial program called the Founders Well Participation Program (Huffingtonpost.com). Adding to the list, in early May, after another Reuters investigation revealed that McClendon had partially owned and helped run a secretive $200 million hedge fund to trade in the same commodities Chesapeake produces, Florida Senator Bill Nelson urged the U.S. Department of Justice to investigate potential market manipulation or fraud by the CEO. On top of all that, more documents surfaced showing McClendon has a unit at Chesapeake headquarters known informally as AKM operations, whose sole purpose is to take care of McClendon’s personal needs. In 2010, firm accountants, engineers, and supervisors handled approximately 3 million dollars in personal work for McClendon. He also owns a 19% share in the NBA team, OKC Thunder, who he mortgaged his future earnings to secure 2 bank loans (reuters.com). Based on all these documents and findings, it appears McClendon has intertwined his personal and business expenses as one entity. This behavior had shareholders worried and upset that he was not looking out for the best interest of the shareholders and the company. All of these investigations, declining stock prices due to the investigations, the declining price of natural gas, and increasing corporate debt led to the co-founder of Chesapeake Energy stepping down as CEO in April 2013. However, lets not forget as bad as 2012 was for McClendon, he still took a small business idea and turned it into a billion dollar company, creating thousands of good paying jobs and clean energy for the United States. He pioneered new
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drilling methods, targeted new areas of shale, and built his natural gas empire in less than 2 decades. McClendon stepping down, in my opinion, was in the best interest of the shareholders and the company. He had run off course and started to do whatever he wanted for his personal gain and was not looking out for the betterment of the corporation. So far, Chesapeake has been doing better this past year with their new CEO. Only time will tell if this was a good decision by the board and shareholders.

References:
1. Special Report: The lavish and leveraged life of Aubrey McClendon. June 2012. http://www.reuters.com/article/2012/06/07/us-chesapeake-mcclendon-profile-idUSBRE8560IB20120607 2. Chesapeake CEO Aubrey McClendon Steps Down After Controversial Year. January 2013. http://www.huffingtonpost.com/2013/01/29/aubrey-mcclendon-steps-down_n_2577300.html
3. Chesapeake Energy website. http://www.chk.com/Pages/default.aspx.
4. What-is-Fracking.com
5. Goodell, J. Rolling Stone Magazine Online. The Big Fracking Bubble: The Scam Behind Aubrey McClendon's Gas Boom. March 2012. http://www.rollingstone.com/politics/news/the-big-fracking-bubble-the-scam-behind-the-gas-boom-20120301#ixzz2iWaE737S
6. Principles of Corporate Finance, 10th edition. McGraw-Hill Corporation; 2011. Pg. 65.

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